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Notes on Taxation

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TAXATION

In this topic, we shall cover the following sections:

Section 1: Definition and types of taxes

Section 2: Principles of taxation

Section 3: Tax evasion

Section 4: Remedial measures for tax evasion

Section 5: Income tax calculations

DEFINITION AND TYPES OF TAXES

Recall how we defined a tax in the topic public finance. We said that a tax is a compulsory contribution
imposed on individual to meet the expenses which are incurred for a common course. This means that a
tax has two main characteristics. Firstly it is a compulsory contribution whereby everybody must pay and
secondly there is no direct service against the payment of tax. This means that despite compulsorily
paying the tax, an individual has no right to demand for services directed to him or her.
Ensuing from this definition is the fact that all the tax income collected is pooled together before
expenditures are done based on the guiding principles discussed earlier under public expenditure. It
should be noted that tax revenue constitutes the highest towards public revenue in country. This is
because of its compulsory nature and the different forms that tax is manifested. The following are some
of the types of taxes:

Income tax- this is tax imposed on income of individuals salaries and other allowances

Corporate tax – this is tax imposed on profits of public limited companies

Sales tax- this is tax imposed on sale of commodities and its imposed on businessmen

Excise tax – this is tax imposed on production of commodities mainly by production industries

Customs duty- this is tax imposed on imports or exports of commodities.

PRINCIPLES OF TAXATION

The concept of taxation and especially the guiding principles have evolved over the years. Specifically,
the first four principles were by an economist Adam Smith while the others were developed after Adam
Smith and are basically expounds on this first four. Let us now explain each of these principles.

Equality: This state that the subjects of every state ought to contribute towards the support of the
government in proportion to their respective abilities. This means that individuals must contribute based
on their respective abilities. Thus, the more you have the more you ought to contribute.
Certainty: This states that the tax which each individual is bound to pay ought to be certain and not
arbitrarily. This means that a proper system should be in place such that individual know their tax
obligation.

Convenience: This states that the tax an individual is supposed to pay should be imposed such that the
time and method of payment is convenient to the payer as much as possible. In fact most taxes are
imposed at source such that the payer does not feel it much. For instance income tax is paid regularly as
the income is paid to the person and is usually done by the employer and remitted to the government.
Also, the price of a commodity is inclusive of the relevant taxes.

Economy: This states that since every tax has cost of collection, this cost should be as minimum as
possible. This means that the tax income should always be more than its cost of collection so as to
generate revenue for the government.

Productivity: This principle states that the tax system should be able to yield enough revenue for the
treasury to avoid deficit financing. This means that the tax revenue should always provide sufficient
funds for the government so as mitigate any deficits in its revenue.

Buoyancy: This states that there should be an increase in tax revenue even if there is no change in tax
base. This means that the tax system should have an inherent tendency to increase with national income
even if the tax rates and coverage are not revised.

Flexibility: This states that authorities should be able to revise the tax structure (coverage and rates) to
suite the changing requirements of the economy.

Simplicity: This principle states that the tax policies should be simple for people to understand and easy
for the government to administer.

Diversity: This principle postulates that there must be different types of taxes so that the tax burden is on
different groups of the society. This is intended to ensure that every person contributes towards
government revenue through payment of tax.
A good tax system is that which fulfills the maximum possible number of these principles of taxation.
Thus an ideal tax system should meet the majority of this principle.

However, the percentage proportion of tax revenue in relation to the Gross Domestic Product in less
developed countries such as Kenya is lower than those in developed countries. This is primarily because
of high tax rates that are intended to raise more funds for the government. This means that citizens in
these countries are taxed heavily and as a result tend to resort to way to evade paying their tax liabilities
by capitalizing on certain loopholes in the tax system

TAX EVASION

Tax evasion: This is a situation whereby an individual fails to meet his or her tax liability as required. This
is possible by capitalizing on existing short falls in the tax system as discussed below.

Information gap in all levels: There are inappropriate records that are maintained by businesses that
have tendency to conceal factual evidences in the name of small businesses. Such people pretend to be
running small businesses in order to pay less tax yet they are running larger businesses.

Complicated tax laws: There have been changing provisions in terms of tax rebates (tax discounts or
waivers) which have been restructured in the form of Value Added Tax through rationalization. It is thus
difficult to tell who to give the tax discount or waiver which at times is given on friendly basis. Also the
inclusion of VAT in the price of certain commodities is not clearly understood to an extend that the
consumers rarely know which commodities attract VAT in their cost hence the charge tax is not remitted
to the government.
Concealment of true ownership: This creates a loop hole whereby one invests the property in another
person’s name say a relative. This makes It difficult for one to trace the source of funds for such
investments.

Imperfect tax administration: Tax officials are not efficient and like any other human being there are
amenable to temptations leading to corruption. The tax laws are also complicated for people to
understand.

Donation political parties: Any receipts to political parties and other Non Governmental Organizations
(NGO) are not taxed yet it is an income. Their accounts and those of high profile personalities are not
audited. Also if you pledge loyalty to the ruling party as a business man you are awarded by not paying
tax.

Remedial measures

In order to increase tax revenue, the government needs to check on the loopholes discussed above.
Below are some measures that can be taken to reduce tax evasion.

There is need to have appropriate conceptual definitions of income and put appropriate tax laws.

There is need to reduce incentives for tax evasion and put obstacles to evasion. This can be achieved by

Lowering tax rates so that people earn more hence taxed more.

Supplementing income tax with other forms of taxes such as tax on expenditure, annual income tax etc.

There is need to have comprehensive returns on personal accounts.

Compulsory auditing of accounts of high income tax payers and assigning code numbers for each.

Donation to political parties to be taxed and all accounts for political parties and other NGOs to be
audited.

Penalty for tax evasion should be related to the tax saved rather than the income concealed. It should
also be increased to make it more punitive.

Adequate attention to be paid to bracket creeping i.e when there is inflation the government increases
salaries of employees to make them get high salary hence pay more tax.
Also tax brackets should be frequently adjusted to take into account of the price raise factor.

Income tax

Income tax: This is a tax levied on every person who earns an income from salaries, wages, commissions,
interest on bonds and savings, dividends on share etc. now, before we look at income tax computation,
let us first define some basic terms used under it. This include:

Gross income: this is the total income earned by an individual in a month or year. It consists of the basic
income basic salary and all the allowances due to the individual.

Relief: this is a tax rebate, discount or waiver given to an individual. It takes the form of personal or
family

Taxable pay: Is the gross income less contribution to registered schemes like pensions or insurance
provided that the scheme is registered with the commissioner of income tax.

Tax liability: this is the actual amount of tax paid by an individual. It is obtained by taking the tax payable
less the relief.

Net income: this is the final amount received by an individual after all deductions have been made. It is
also referred to as the take home package and is calculated as

Net income = Gross income-(tax paid +contribution to registered schemes + any other deduction).

Example1
An employee in a certain company drew the following benefits in the month of April 2011: Basic salary
Kshs. 20,000, House allowance Kshs. 15,000, Medical allowance Kshs. 8,000, Car allowance Kshs.
8,500, Entertainment allowance Kshs. 5,500 and Responsibility allowance Kshs. 7,200. During the
month the employer made the following payments: Kshs.430 to NHIF, 5% of basic salary to a registered
pension scheme,3 % the basic salary to the cooperative for shares and Kshs.12,000 to a medical chemist
for the drags he had taken. In addition an employee received a tax relief Kshs.1, 056. Using the tax
schedule below calculate the employee’s

A) Gross income

b) Taxable pay

c) Tax charged

d) The net income.

Tax schedule

Income (Ksh) tax rate (%)

1-10,800 10%

10,801-21,600 15%

21,601-32,400 20%

32,401-43,200 25%

43,201 and above 30%

a) Gross income = basic salary + all the allowances received

Basic salary Kshs. 20,000.00

House allowance Kshs. 15,000.00

Medical allowance Kshs. 8,000.00

Car allowance Kshs. 8,500.00

Entertainment allowance Kshs. 5,500.00

Responsibility allowance Kshs. 7,200.00

Gross income Kshs. 64,200.00

b) Taxable pay = Gross income – contribution to registered schemes(pension scheme)

Gross income Kshs. 64,200.00

Less pension scheme (5%of20, 000.00) Kshs. 1,000.00

Taxable pay Kshs. 63,200.00

We use the tax schedule to tax the amount for taxable pay. This is because the deductions towards
registered schemes shall be taxed at the time of payment.

1st 10,800= = 1,080.00

2nd 10,800= = 1,620.00

3rd 10,800= = 2,160.00

4th 10,800= = 2,700.00

5th

Total tax =13,560.00

Less Relief = 1,056.00

Tax charged = 12,504.00

d) Net income = Gross income-(tax charged +pension + all other deductions)

Gross income Kshs. 64,200.00

Less pension scheme (5%of20, 000.00) =Kshs. 1,000.00

NHIF = Kshs. 430.00

Medical Chemist = Kshs. 12,000.00

Shares (3% of 20,000.00) = Kshs. 600.00 Kshs. 25,534.00

Net income Kshs. 38,666.00

Example 2

An employee draws the following benefits in a month: Basic salary Kshs. 37,650.00, House allowance
Kshs. 36,600.00, Subsistance allowance Kshs. 2,900.00, Car allowance Kshs. 4,400.00, Responsibility
allowance Kshs. 800.00 and a non contributory medical scheme. In a month the employ contribute 10%
of basic salary to a registered pension scheme, Ksh. 320 to NHIF, 15% of basic salary to cooperative
society and 400 to the union for all employees. The employee is however entitled to a personal relief of
Kshs. 1,080 per month. Using the tax schedule provided calculate above, calculate the employees:

a) Gross income per year.

b) Yearly taxable income

c) Monthly tax charged

d) Net monthly income received

a) Gross income = basic salary + all the allowances received

Basic salary Kshs. 37,650.00

House allowance Kshs. 36,600.00

Subsistance allowance Kshs. 2,900.00

Car allowance Kshs. 4,400.00

Responsibility allowance Kshs. 800.00

Gross income Kshs. 82,350.00

Gross income per year = Kshs. 82,350.00 p.m X 12 months = Kshs. 988,200.00

b) Taxable pay = Gross income – contribution to registered schemes(pension scheme)

Gross income Kshs. 82,350.00

Less pension scheme (10% of 37, 650.00) Kshs. 3,765.00

Taxable pay Kshs. 78,585.00

Yearly taxable income = Kshs. 78,585.00 p.m X 12 months = Kshs. 943,020.00

1st 10800= = 1,080.00

2nd 10,800= = 1,620.00

3rd 10,800= = 2,160.00

4th 10,800= = 2,700.00

5th

Total tax =18,175.50

Less Relief = 1,080.00

Tax charged = 17,095.50

d) Net income = Gross income-(tax charged +pension + all other deductions)

Gross income Kshs. 82,350.00

Less pension scheme (5%of20, 000.00) =Kshs. 3,765.00

Tax charged = Kshs. 17,095.50

Union dues = Kshs. 400.00

Shares (15% of 37,650.00) = Kshs. 5,647.50 Kshs. 27,228.00

Net income Kshs. 55,122.00

EXERCISES

Mrs Olive is a personnel manager with a certain company. She has a basic salary of 26,000 per month,
House allowance 20,000; Substance allowance 2,500; Responsibility 4,000; Car allowance 8,000 and
Medical allowance 5,000. She contributes 10% of basic salary to a registered pension, 320 to NHIF; 200
to NSSF and 500 for service charge. In addition she pays 1000 to her cooperative society every month
and she has a personal relief 1,056 per month.

Required: Calculate

a) Gross income per month and for the whole year.

b) Her monthly and yearly taxable income.

c) Her monthly tax liability.

d) Her monthly tax liability.

(a) Gross Income =37,650+36,560+2900+800+4040 = 81,950 per month.

Annual Gross Income = 81,950x12months = 983,400/= per year.

(b) Taxable income =983400-() = 938,220/= per year.

Taxable income per month = 81,950-3,765 = 78,185

© Monthly tax charged

=10,800

=1,620

=2,160

=2,700

=10495.5

=18055.5

Less relief = 1080.0

16,975.5

=16,975.50/= per month.

=81,950-(16975.5+320+400+5,647.5) = 81,950-23,343 = 58,607/= per month.

Gross income

26,000+20,000+2,500+4000+5000+8,000

=65,500 per month.

=65500x12=786,000 per year.

Taxable pay = 65,500-2,600 = 62,900/= per month.

62,900x12=754,800/= per year.

Tax charged

10,800=1,080

1,620

=2,160

=2,700
=

Relief 1056

12,414